Tuesday, July 19, 2011

After spending several weeks in neutral in a market that lacked directional conviction, the Asset Inflation Deflation Timer Model has moved from a "neutral" to an "inflation" reading. This condition signals that the model portfolio should orient itself to the risk trade, namely inflation hedge vehicles, such as shares of commodity producers, emerging market equities and TIPs.

The Timer Model depends on commodity prices as a leading indicator of global growth and inflationary expectations. The chart below of commodities as measured by the CRB Index, shows that commodities have been rallying in the face a recent bout of equity weakness, which is constructive for the "buy risk" trade.

The chart below of commodity prices compared to equity prices shows the relative uptrend in a more dramatic fashion:

We have gone through, I don’t know how many recessions, perhaps 15 in the history of this country.
But, our system over-shoots periodically. And in this particular case we had a huge bubble. So the fact that there’s a correction after that should not be unexpected. But our system always comes back and it will this time. And it already is...

We will come back big-time on employment when residential construction comes back. And we way over-produced in houses. I mean we were forming a million or 1.2 million households and we were building close to two million residential units.”

Big surprise, we ended up with too many houses. We’re not going to blow them up. We’re not going to have kids start getting married at 12 or something. There’s a natural correction. The only way a correction takes place is to have households formation exceed new construction by a significant amount for a significant period of time.

We’ve had it for quite a while. And when you see these figures of five or 600,000, that means we’re sopping up housing inventory and I don’t know exactly when that hits equilibrium, but it isn’t five years from now I know that. And I think it actually could be reasonably soon.

A commodity-equity disconnect?
On Monday, stocks tanked while gold rallied past $1,600, likely on concerns about systemic financial risk in the US and Europe. In my discussions I was asked if there is a possibility of a disconnect between gold (and commodity prices) and equities (and the "risk" trade).

I would answer that question in a number of ways. First of all, while gold and other precious metals can be regarded as an alternate currency to the fiat currencies, the move in commodity prices has been broadly based. Consider, for example, Dr. Copper:

...or the agricultural commodities, as measured by the ETF DBA:

John Murphy of stockcharts.com also recently pointed out that equities and commodities remain closely correlated, though they haven't always been correlated in the past:

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In short, the fact that commodity prices are rising in the face of all this bad news can only be interpreted constructively for the global growth outlook.

Risks to the trade

The initiation of a new position by the Timer Model is always fraught with risk. I am closely watching the behavior of Banks against the market. The relative underperformance of the Banking Sector is a source of concern. As the chart below shows, the sector has broken down below a major relative support level and remains in a relative downtrend. While the sample size is low, past occurences have signaled major market dislocation, namely the Russia Crisis (1998) and the Subprime Crisis (2007), which didn't result in a market meltdown until a year later in 2008.

Any investor who buys "risk" at this point, as the Timer Model is doing, has be concerned about the tail risk of a European sovereign crisis or the possibility of a US default. Neverthless, commodity prices have been able to signal past financial meltdown episodes, i.e. the Lehman and Russia Crisis. Still, I expect to enter into this trade with tight stops as a way of defining my risk tolerance.

Addendum: Further to my post, Erik Swarts of Market Anthropology confirms the Timer Model signal. He analyzed the silver-gold ratio and concluded that risk appetite is on the rise and "equity markets are substantially undervalued".

1 comment:

Thank you for sharing this excellent analysis. Like all you do, it's thorough and comprehensive (given the limited blog space).

You also spoke of cautionary factors... and so followers of this Model will be pleased to observe a sharp (albeit one-day) upward spike in the very BKX:SPX ratio chart you highlighted as one of the concerns.

Also, the TLT to CRB (or DBC etf, as proxy) ratio is again moving in a favorable direction...

Your work is invaluable to my market analysis and I'm sure many other readers feel this way as well.

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Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

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